Presentation by Raj Desai, Professor at Georgetown University and Senior Resident at the Brookings Institution at SITE Development Day 2017

1. Development Day 2017
Stockholm Institute of Transition Economics
Stockholm, May 31, 2017
Raj M. Desai
Georgetown University and
The Brookings Institution
Homi Kharas
The Brookings Institution
Magdi Amin
International Finance
Corporation
GoodBusiness
Development
&
COMBINING

2. Motivations
• Investors look at firms’ financial performance to guide capital
allocations
• Increasingly, they also look to sustainability and social responsibility
• There is now a growing movement to integrate sustainability into the
practices of all firms
• Some developing countries have expressed concerns that high costs
and new conditionalities for sustainability could undermine growth

3. The origins of the debate: The 1930s
The corporation is an economic
institution which has a social service
as well as a profit-making function.
Corporations are necessarily and at
all times exercisable for the ratable
benefit of all the shareholders.
Adolph A. Berle E. Merrick Dodd

4. The debate (cont’d)
There is one and only one social
responsibility of business—to use its
resources and engage in activities designed
to increase its profits…
Milton Friedman
Business Week survey (2000):
“Do you think Milton Friedman
was right?”
Yes = 4%
Accenture/UN Global Compact
Survey of international CEOs
(2014):
“Should multinational
corporations lead efforts to define
and deliver new goals on global
priority issues?”
Yes = 84%

5. Sustainability vs. performance
• Central question: can socially responsible investors expect the same
return as traditional investors?
• YES: returns are expected to be commensurate with the higher risk
associated with impact investing
• NO: returns on impact investing will be constrained by poor
governance and market failures
• MAYBE: the relationship between social responsibility and
performance depends on external (country/regional factors)

6. Meta-evidence
0%
20%
40%
60%
80%
100%
Practioner Academic
Positive Negative Neutral/Mixed
• Balance of evidence is that
sustainability  better financial
performance
• BUT
• Most involve publicly listed
companies in OECD countries
• Definitions of “sustainable” or
“socially responsible” vary

7. Evidence, cont’d
• Pooled internal rate of return of 170 investments made by 32 impact
private equity funds (2000 – 2014) = 12.9% ≈ small-cap benchmarks
(Wharton Social Impact Initiative)
• Private equity and venture capital funds with impact missions
produce same returns as traditional funds (Global Impact Investing
Network)
• Meta-analyses show that social and environmental responsibility pays
off (Harvard Business School)
• BUT: little empirical evidence of any trade-offs at the firm level
between creating more market improvements and more financial
returns

8. Establishing causality
• Actions to increase
sustainability can trigger good
financial performance
• But positive returns can permit
additional investments in
sustainability
• Sustainable practices and solid
financial performance may
result from good management
• Sustainability can have an effect
on the “metrics” used to
measure financial performance

9. International Finance Corporation data
• We use the ratings of the Development Outcome Tracking System
(DOTS)
• Baseline indicators for environmental, social, and governance (ESG)
• As the project matures, indicators are monitored on a yearly basis until
project close
• 4-point scale from excellent (1) to unsatisfactory (4)
• IFC Reach Database also has indicators of ROIC/ROE
• Data cover the period 2006 to 2015, encompassing investments in
2,477 unique clients (many, many missing observations)

10. 0
10
20
30
40
50
60
70
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
%
1
2
3
4
Environmental, social, governance (ESG)

11. Mean ESG, 2005 – 2014

12. Mean returns, 2005-2015
0
5
10
15
2005 2010 2015
%
ROE
COE
ROIC
WACC

13. What about causality?
• A problem with any indicator that is partially subjective is measurement
error
• Random = idiosyncratic problems with collecting information on the firm, etc.
• Systematic = rater bias (which, we know, exists)
• In the case of DOTS, ratings may be affected by factors related to/affecting
financial performance
• If factors that bias ratings also influence financial outcomes, then we
cannot claim a causal relationship
• Need to control for possible sources of measurement error/bias, as well as
for the possibility that financial performance  ESG
• In other words, we need to control for things that affect ESG but that do
not directly affect financial outcomes

14. Our approach
• Political influence and of countries is a factor in development
assistance
• Examples
• Countries serving as temporary members of the UN Security Council are more
likely to receive World Bank projects
• Temporary UNSC members receive more US and IMF money
• We consider “influence”  presence of the country on the UN
Security Council

15. Our approach (cont’d)
• Institutions of countries are a factor in ESG ratings
• Examples
• For > 2,000 publicly listed firms in 42 countries, 40% of the variation in ESG is
explained by country institutional factors (legal, corruption)
• Therefore we also examine the effect of a country’s environmental
policies on firm-level ESG ratings

16. ESG and profitability
0.40
0.45
0.50
0.55
0.60
0.65
4 3 2 1
ProfitabilityLikelihood
ESG Rating
NARROW
DEFINITION
BROAD
DEFINITION

17. Results, part I
• In raw data, ESG has strong, positive correlation with financial and
economic performance
• A one-step improvement in the ESG indicator raises
• likelihood of profitability by 5 percentage points
• return on capital/equity by 2 percent
• BUT: unadjusted subjective indicators are not good variables for
statistical analysis

18. Results, part I (cont’d.)
• Other results
• GDP per capita has no impact on profitability
• Investments in fragile states are not less profitable
• Financial sector investments have higher profitability than real economy
investments (but trend is negative)
• Larger size projects are more profitable
• Country macroeconomic conditions matter

19. Results, part 2: ESG and profit (adjusted)
RETURNS “ECONOMIC” RETURNS

20. Results, part 3: path analysis
• ESG does not appear to have any
positive OR negative effect on
profitability
• Can ESG benefit the community
development in the long run?
DEVELOPMENT
IMPACT
Z X
δz δx
ε3
ε2ε1
Sustainability Profitability

21. DEVELOPMENT
IMPACT
Sustainability Profitability
+0%
+18%+3.5%
DEVELOPMENT
IMPACT
Sustainability Economic Profitability
+0%
+12%+2.4%

22. Thank you
For further information, please see the full report at:
https://www.brookings.edu/research/combining-good-business-and-good-development/

23. Two-stage least squares (2SLS)
• Identification of underlying ESG value through country-level
instrumental variables (IV)
• Membership in the UN Security Council
• Environmental Performance Index
• Assumptions for Validity
• Instruments should be correlated with DOTS ratings (they are)
• Instruments should not affect financial performance directly (they don’t)

24. Estimation
• First stage:
𝑑𝑖,𝑡 = 𝛼0 +X 𝑖𝑡
𝛼
𝛼X +𝑅𝑖𝑡 𝛼2 + year𝑖 𝛼3 + 𝑒𝑖𝑡
• Second stage:
𝑦𝑖,𝑡 = 𝛽0 +X 𝑖𝑡
𝛽
𝛽X +𝑑𝑖𝑡 𝛽2 + year𝑖 𝛽3 + 𝜖𝑖𝑡
• d = DOTS rating
• R = influence
• y = return on equity/invested capital
• X = vectors of project and country controls

25. 2SLS results
• Two-stage least squares (2SLS)
1st: Predicted ESG = f1(UNSC membership, EPI, controls)
2nd: Financial Performance = f2(Predicted ESG, controls)
• In 1st stage, country UNSC membership and EPI positively affects firm-
level ESG score
• In the 2nd stage, relationship between ESG and profitability disappears

26. IV validity: partial residual plots